Presenting The Fundamental Flaw In The Fed's Thinking

Tyler Durden's picture

This one simple chart below shows what is possibly the biggest and most fundamental flaw in Bernanke's approach to spurring the economy, which to him, of course, means rising prices of risky assets, aka the stock market.

The chart above shows the return of two simple things: the return of 4.25% 30 Year Bond issued November 2010... and the S&P.

As is vividly shown on the chart, the return of the long-bond is nearly three times greater than that of the broader equity market in 18 short months!

And therein, ladies and gentlemen, lies the rub.

Recall that Bernanke said something substantively as follows:

"When our policy response lowers interest rates on govt bonds, it induces market participants to take more risk.  Someone selling their govt bond to us may go out and buy a corp bond, thereby lowering spreads. A bank selling their govt bond to us may go out and make a loan..." 

There is one problem with this logic: it is dead wrong. Because instead of forcing investors to rush out of the bond market, which potentially has much more upside embedded (the 30 Year is yielding 2.7% right now: this means the actual price of the 30 Year can continue going up and up and up), investors, even those "sophisticated" ones at banks, hedge funds, and prop desks who can trade CDS, IR Swaps, variance swaps, swaptions, and things the retail investor has never heard of, are doing something else, and something much simpler, entirely.

They are simply front-running the Fed!

The Fed's entire policy of boosting the economy is a failure for many reasons, but the primary purpose embedded therein - to lift stock markets, will forever be subordinated (to use the parlance of our times) to just frontrunning the Fed, which simply means buy whatever the Fed is buy, and sell whatever (if anything) it is selling.

In simpler format:

  1. Frontrun what the Fed has publicly telegraphed to be doing
  2. ...
  3. Profit

And as long as the Fed continues on the course of LSAP, either unsterilized or sterilized ala Twist, this will continue, and the Fed will continue failing upward.

Sadly, this also means that at the end the Fed has only one option: to go Japanese and start buying not only REITs and ETFs, but ultimately individual stocks.

At that point the best purchase, however will not be the stock market, but wheelbarrows.